Oil prices rally but rebound’s stamina uncertain

Oil producers' brutal run of budget cuts and layoffs has turned more hopeful, as global prices rebound from their winter lows.

The rapid moves by U.S. shale producers to reduce production – coupled with geopolitical risk in the Middle East – has sparked a rally that is also being fuelled by hedge funds and other money managers betting on crude's recovery.

Still, the durability of the current rebound remains a question.

The industry faces the risk of a double-dip in oil prices later this year when hard-pressed producers look to take advantage of the upswing and bring more crude onto the market.

"The crude oil rally lacks room to run," Greg Priddy, global energy analyst with New York-based Eurasia Group, said in a note.

"The current market focus on a near-term U.S. production peak ignores major production increases elsewhere."

Traders are clearly feeling upbeat. While North American prices retreated somewhat on Friday, the trendsetting West Texas intermediate has staged an impressive run since mid-March, climbing from a low of $43.46 (U.S.) a barrel on March 17 to close this week at $57.13. North Sea Brent has had a similar rebound. After hitting a low of $46.59 a barrel in mid-January, Brent has climbed to $62.58 a barrel, its highest close since the middle of December.

Money managers have extended their bets on crude's continued rise. Hedge funds and other investors this week increased their exposure on crude futures contracts and sold off their short positions – bets on a price decline – according to the Commodity Futures Trading Commission. The speculators' bet on rising prices is the highest it has been since last July.

As North American traders focus on the prospect of U.S. production declines, the bigger questions loom – as they so often do – in the Middle East. Iran and Saudi Arabia are engaged in a proxy war in Yemen that could threaten shipping lanes even as Western powers led by the United States seek to conclude a nuclear agreement with Iran that could put more barrels of crude into the market.

Saudi Arabia has already boosted production to reclaim market share from competitors in North America and indeed OPEC itself. Mr. Priddy said the kingdom is unlikely to ratchet back to make room for its regional arch-rival Iran in the event that sanctions are lifted, either formally under a U.S.-led agreement or through a fracturing of the united front that brought the Persian theocracy to the bargaining table.

The risk from Yemen is small, Mr. Priddy said. "The much larger issue is the potential for a return of Iran to the market – and even the anticipation of such a return – to intensify the focus on [protecting] market share by the Saudis," he wrote.

Conditions in North America point to a market that is coming into better balance. While there is debate about the exact timing, it is clear the U.S. shale oil production is peaking – or soon will – and will begin to fall this summer, while demand climbs on the twin impetus of a strengthening American economy and low pump prices during the traditional holiday driving season.

But there is an ocean of crude waiting to flood into the market as prices rise, said Michael Lynch, president of Strategic Energy & Economic Research Inc., in Massachusetts.

Storage tanks are brimming and U.S. shale producers have a huge inventory of wells that have been drilled but not completed, which means they can be quickly brought into production.

Mr. Lynch said the price rally could peter out if producers take advantage of the rebound to boost volumes, particularly in the fall when demand typically falls.

Futures trader Phil Flynn is more bullish, expecting WTI prices to hit $75 a barrel by the end of the year. In contrast, the federal government – using an average of private sector forecasters – assumed West Texas intermediate will average only $54 a barrel this year and $67 in 2016.

The number of oil rigs operating in the U.S. fell for the 20th straight week to 703, according to Baker Hughes Inc. That's the lowest level since October, 2010, and is down 55 per cent from the same time last year.

"We've seen one of the most historical pullbacks in energy investment and activity that we've ever seen," Mr. Flynn said. "It can be amazing how quickly we can recover and how quickly we can go from a situation of glut to one in which the market is tightening up."